Absorption of Manufacturing Overheads

Absorption of manufacturing overheads refers to the process of allocating and distributing overhead costs to individual units of production. Overheads are indirect costs, including factory rent, electricity, maintenance, and depreciation, that cannot be directly traced to specific products. Proper absorption ensures accurate cost determination, aids in pricing decisions, and maintains profitability. Various methods are used to absorb these overheads into product costs based on estimated or actual expenses.

Need for Absorption of Manufacturing Overheads:

Absorption of overheads is necessary for several reasons:

1. It ensures the total cost of production includes all direct and indirect expenses.

2. It helps in accurate pricing by incorporating overhead costs into product costs.

3. It facilitates budget preparation and financial planning.

4. It provides a basis for performance evaluation and cost control.

5. It ensures compliance with accounting standards and reporting requirements.

Methods of Absorbing Manufacturing Overheads:

1. Percentage of Direct Material Cost Method

In this method, overheads are absorbed based on a percentage of the direct material cost. It is suitable for industries where material costs form a significant portion of the total cost. However, it may not be ideal if labor and machinery usage vary significantly between products.

Formula:

Overhead Absorption Rate = [Total Overheads / Total Direct Material Cost] × 100

2. Percentage of Direct Labor Cost Method

Here, overheads are allocated based on a percentage of direct labor costs. This method is appropriate when labor is a dominant factor in production. However, if automation is high, this method may lead to inaccuracies.

Formula:

Overhead Absorption Rate = [Total Overheads / Total Direct Labor Cost] × 100

3. Percentage of Prime Cost Method

Prime cost consists of direct material and direct labor costs. This method assumes overheads are proportional to prime cost, making it suitable for industries with uniform production processes. However, it may not be appropriate for industries where factory expenses are more influenced by machine usage.

Formula:

Overhead Absorption Rate = [Total Overheads / Total Prime Cost] × 100

4. Direct Labor Hour Rate Method

This method absorbs overheads based on the number of labor hours used. It is effective in labor-intensive industries but less useful in automated industries where machine usage is a significant cost driver.

Formula:

Overhead Absorption Rate per Labor Hour = Total Overheads / Total Direct Labor Hours​

5. Machine Hour Rate Method

This method is used in industries where machines play a major role in production. Overheads are absorbed based on machine hours, making it ideal for highly automated manufacturing processes.

Formula:

Overhead Absorption Rate per Machine Hour = Total Overheads / Total Machine Hours​

6. Rate Per Unit of Output Method

In this method, overheads are allocated per unit of production. It is effective when all units are identical. However, in industries producing multiple products with different cost structures, this method can be misleading.

Formula:

Overhead Absorption Rate per Unit = Total Overheads / Total Number of Units Produced​